Monday, November 14, 2011


of RBI for 2nd Quarter of FY 2011-12

=Analysis & Suggestions =

RBI’s Monetary Policy Review is always a much awaited exercise -  by the country. It provides elaborate economic justification for the decisions that the review finally takes. There is no doubt that the review is a highly enlightened exercise as far the review of the economy goes.

But, given the complexities of the Indian Economy and the functioning of the Central and State Governments, which are not always in Tandem and harmony with the RBI’s Monetary Policy, the policy decisions of the RBI do not always achieve the end results desired by it.

RBI has been raising Interest rates (repo and reverse repo rates) during last 2 years – embarrassingly FREQUENTLY - but, these Policy actions of RBI have not yielded the results expected by RBI – so far.

On the other hand, Food Inflation has crawled steadily but surely into DOUBLE DIGITS and HOVERS around 11-12% - which is uncomfortably HIGH for India –and nothing in the RBI Review can explain the same. The Inflation in respect of non-food products is equally worrysome. During the LAST 2 YEARS, it is an undeniable fact that INFLATION did not respond to RBI’S monetary Policy stance.

On the other hand, the growth in Industrial Production has now fallen to a measly 1.9% in September,2011.Given the way statistics are compiled in India, which also needs definite improvement, one may even suspect a negative growth – if not in September, in the months ahead.

For the second Quarter of FY 2011-12, Net profit of over 1200 publicly listed companies (excluding banking, finance and oil and gas) are reported to have fallen by 28.5% from the year ago period. ET reports that this fall is sharper than the fall in the sub prime crisis of 2008. The steep increase in interest costs on corporate Debt must have played a major role in this downturn.The demand downturn in auto, housing and many other segments  must also be partly attributed to this rise in Interest rates.

This is bound to happen due to the double edged sword wielded jointly by the Government on one side and RBI on the other side.

Thanks to the raise in prices of Oil, Gas, and many other raw materials  either directly or through high taxes by Government, the Indian companies are already under high stress – compared to – say, the Chinese or the Americans – especially the Chinese. Government is making our companies highly uncompetitive compared to the Chinese, Thailand, and other east Asian companies. Taxation policies must not only look at Government plans and ideas – like increasing NREGA scope etc – but must also look at what is happening outside India – which affects Indian companies. Otherwise – all policies and Progams of the Government will  fall flat over the medium to long term.

Look at our Pre-Budget reviews etc. Almost nothing is there on how the Chinese goods, Thai Goods etc are affecting Indian economy and production and sale of Indian Goods - and how the Budget addresses these concerns. How do we sell more Indian Goods within and outside India? Ultimately, this is what will increase Government revenues.

So, oil and Gas prices go up – every time there is a rise in the world market. After all Indian Oil marketing companies need to be propped up. But, this affects all other companies, shops, traders and households in India adversely - in many ways. Haven’t you seen in a traffic Jam – where one lorry speeding slightly – and  hitting another before it, doesn’t stop with that. Each goes on hitting the one before and a thousand vehicles before each other may get damaged. When oil prices, gas prices, electricity prices etc are directly raised, this is what happens in an economy – which is already prone to High Inflation due to other reasons.

Now, in the second stage comes the RBI, looking at the high Inflation numbers. And RBI is religiously intent on controlling Inflation – somehow. But, it has only one Instrument in its hand for this. It has been using this one Instrument for the last 2 years, admittedly with NO SUCCESS.

For the second quarter of FY 2011-12, the RBI has made its review and given out its following decisions, which are on the same lines as earlier :

Ø Increase the repo rate under the liquidity adjustment facility (LAF) by 25 basis points. The repo rate will accordingly move up from 8.25 to 8.5 per cent.

Ø The reverse repo rate under the LAF, determined with a spread of 100 basis point below the repo rate, gets calibrated to 7.5 per cent. 

Ø The marginal standing facility (MSF) rate, determined with a spread of 100 bps above the repo rate, stands adjusted at 9.5 per cent.

Ø The RBI has also decided to deregulate the savings bank deposit interest rate with immediate effect. I will come to its details later.

This RBI Policy action presupposes that all the economic variables impacting the INFLATION SPIRAL are under the broader control of RBI and are susceptible to Interest Rate Adjustment. Is this really so?

While it is true that Deficit Financing of expenditure by Central and State Governments is overseen by RBI to some extent – it is not really controlled by it.
The raising of oil, gas, coal, electricity and other basic goods rates is totally outside the purview of RBI.

Interest Rates on Bank Deposits and Bank Credit are under control of RBI, and are susceptible to monetary Policy actions of RBI.

All other economic variables impacting the Inflation spiral are not under RBI’s control. RBI’s monetary Policy becomes  ineffective unless all economic variables impacting the Inflation spiral are also controlled by the various authorities responsible for their control. This has been pointed out by this Blog several times earlier.

From a Basic sense of Economics – we can say, the following major factors are responsible for Inflation :

1.   If Production is stagnating but Demand is rising : Prices will move up leading to Inflation. Production and demand are both product specific Factors. If tomatoes are not produced but there is huge demand for it, tomato prices will rise. But, if onion supply is more than demand, its prices will fall. Sometimes, a common factor like LACK OF RAINS OR FERTILIZER may result in general lower production of vegetables and food grains – which may result in generalized food Inflation.

SOLUTION : There is need to identify the products whose prices are rising and the specific causes therefor – and attend to those causes.

2.   Production may be adequate for the Demand – but Supply / logistic constraints may result in artificial scarcities : This can push up  prices and Inflation. This too is product specific. Some supply constraints are more generalized – like lack of storage facilities, transport constraints etc – which result in rise in prices across a category of products. Sometimes, Traders may collude and create artificial supply scarcities – just to raise prices.

SOLUTION : Removal of the specific supply constraints is the solution. Governments need to constantly monitor and prevent hoarding activities of traders - which creates artificial scarcities.  The hoarding activities which create artificial scarcities cannot be construed as a JUST ECONOMIC ACTIVITY. This needs to be dealt with firmly.

3.   Money supply increases through Bank Credit : This will push up Demand even while supply is stagnating. This will raise Prices and lead to Inflation.

SOLUTION : Bank Credit pushes up demand for ONLY THOSE PRODUCTS for which the Bank credit is made available. Bank Credit is product specific – like auto loans, home loans etc – and these are not sectors where supply is stagnating. In these categories, more the Bank credit, more is the growth of these sectors, with no increase in prices. Right now, due to lesser Bank credit, or costlier Bank credit, Growth in these sectors is adversely affected.

The additional money supply that results from Bank Credit – will mostly go back into manufacturing and other productive or Growth oriented  activities rather than CONSUMPTION activities. For instance, retained profits, dividends and rent components of the rise in company incomes goes back mostly into productive activities. The only other component of Incomes, namely wages, is a FIXED INCOME which is dependent on wage agreements, annual increments etc – and does not increase merely because of demand for products or because of increasing Bank Credit. Therefore, these Growth sectors do not cause inflation on account of Bank Credit and must be released from credit constraints. As of now, Growth in these sectors has come down drastically because of enhanced bank rates.

Bank credit to Agricultural sector also is production oriented. It will in fact result in LOWER Prices down the line when production increases. Therefore, Most of the Agri sector Bank credit reverses Inflation and does not cause Inflation. The probability is – increasing interest rates may be hitting agriculture adversely in some manner.

Bank Credit for SMEs etc – may be resulting in Inflation to a certain extent. But curbing the credit to this sector may result in unemployment in large numbers.

RBI’s Deficit financing of Government expenditure : This is Inflationary to the extent the Government expenditure is non-productive. It is true that schemes like NREGA, which have very little component of production – are INFLATIONARY. These schemes need to re-orient – to make them much more productive than at present. This is very much possible and desirable. There is of course, no need to scrap the schemes. Likewise, deficit financing of state Governments’ expenditure is also Inflationary in many cases. Any financing of unproductive expenditure under many schemes of the Governments is Inflationary in character. But, RBI’s Monetary Policy actions do not in any way limit these expenditures.

4.   Invisible money supply from Non-Governmental and Non-RBI sources : This is one of the big causes of Inflation. Such invisible Money supply may be in the forms of (i) Black money generated within India and (ii) Fake currency coming from foreign and Indigenous sources. Both these sources of illegal money can push up Inflation quite a bit.

SOLUTION : Black money generation must be stopped at all costs. Black money can be inflationary in many ways and no amount of RBI and Government Policies on Inflation control can succeed unless Black money generation is rooted out.

While estimates of Fake currency in circulation in India vary, their origins / roots in certain foreign countries raise more worries than mere Inflationary pressures. There is need to destroy these sources of Fake currency, whether indigenous or foreign, mercilessly.

Black Money Generation and circulation can only be tackled by Government and RBI through joint action. Checking and arresting Fake currency needs to be done jointly by Banks and Government.

5.   Prices of Basic, International commodities like CRUDE  are rising – and India chooses to raise their domestic Prices also in tandem. This may give some relief to Oil marketing companies – but, this will definitely send the prices of oil and all of its linked commodities into an Inflationary spiral. Oil and Gas are raw materials for many Industries. Hence, the goods and service produced by the user Industries will also suffer higher prices. It is a very spacious argument that raising oil / gas prices does not lead to Inflation. It does lead to all round Inflation. Even RBI’s Monetary Policy acknowledges that it leads to Inflation.

SOLUTION : It is better for the Government to absorb these increasing international prices of crude and Gas through taxation measures and by providing timely subsidies to Oil marketing companies – rather than passing on the additional burden to the consumers directly.

In both cases, the tax payers only bear the final cost whether it is passed on through taxes or through DIRECT INCREASE IN OIL AND GAS PRICES.

The advantage in absorbing it through taxes is – generalized and cascading Inflation effect is much less in the economy if the absorption is through Taxation and subsidies to OMCs.

If the direct additional taxation / subsidies needed is, say, Rs.30,000 crores, the impact on the tax payer is just this and nothing more. But, if the oil / gas prices are raised, there will a cascading effect on the prices of many other commodities. The over all  inflation impact on the economy in this case will be, in my opinion,  over Rs.1,00,000 crores- more than three times of direct taxation effort to foot the oil / gas bill.

Any passing on of additional prices on oil / gas must be attempted only when INFLATION comes down to around 4 - 6% again.

6.   There can be structural Inflationary Pressures  in specific commodities – due to action / inaction of Governments (central / state) and private sector producers, suppliers and consumers. Examples of this can be – (i) export of a commodity whose domestic prices are high in the country. (ii) Levy of VERY HIGH TAX RATES on  specific commodities /services, especially in the raw material and intermediate products categories (iii) Constraints on Free Movement constraints of specific commodities from district to district and state to state (iv) Economic Blockades of the type seen in Manipur. There are many such temporary and long term constraints that can result in huge price increases in the final consumer products. Lack of transportation, storage, marketing and other facilities also result in such increase in prices.

SOLUTION : The obvious solution is to remove these constraints and ensuring appropriate policy actions.

We can list out a lot more – but, by and large, the above listed ones are the factors that generally push up prices and result in Inflation spiral.
Item No.3 above seems to be the only one which is susceptible to periodical RBI Monetary Policy measures. But, Interest Rate measures make credit dearer for even the most productive sectors, without impacting the Inflationary pressures in other sectors.
All the other factors are largely in the domain of the central and state Governments (respective Ministries) – which must act on the specific causative factors in each instance.
There is therefore need for all core Ministries at the Centre and states – (i) to identify the products caught in the Inflationary spiral individually (ii) to assess the reasons for the steep increase in their prices and (iii) identify the Policy measures that can effectively tackle the Production, supply, demand, and price factors – so that India achieves definite Growth levels with tolerable Inflation limits.

That sort of co-ordinated exercise by the central and state Ministries is the need of the hour – to tackle the current Inflationary spiral. All Government and RBI pronouncements are more in the nature of an expectation that Inflation will come down in DUE COURSE , when supply and demand pressures ease, but we need more of positive action to address each Inflation causing factor.

Therefore, there is need for each central Ministry – to look at the twin issues of Inflation and Growth of the commodities under its control – and bring out a white paper on ALL THE CAUSES that have contributed to high prices and identify the MEASURES needed for bringing down the prices.

There is also need to co-ordinate with all state Ministries – to identify the causes for inflation in specific states – clearly looking at all production, supply, demand and price issues in each state (by the respective state Ministries).

There has to be at least a quarterly meeting of the Central and State Ministers and Secretaries – to tackle these issues. This, in my opinion, is the immediate need, to tackle Inflation.

On the other hand, since the economic variables responsible for current Inflation cannot be impacted by RBI through Interest rate adjustments, and since the interest Rates are now at ALL TIME HIGHs – and clearly and adversely impacting Growth in several sectors – there is a need to Roll back these High Interest Rates by at least 2 percent from current levels.

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